L3Harris Technologies, Inc. (LHX) Earnings Call Transcript & Summary

Good morning, everyone. Today, we're hosting L3Harris with CEO, Bill Brown; and SVP and CFO, Jay Malave. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representatives. With that, I'll turn it over to you, Bill, and welcome.

Thanks for hosting us, Kristine and congratulations on the launch of your coverage. Maybe just a couple of comments from my side before we get to your questions. So we're now just over a year into the merger between L3 and Harris, and the combination playing out consistent with our initial expectations or better. The operating model is in place, our metrics around margins, working capital and cash flow all show the benefits of the consolidation. One thing that we couldn't anticipate was COVID, but we've been able to offset the headwinds from a bottom line perspective as the L3Harris team has executed, I think, very, very well. And we see this momentum continuing in a range of environments as we look ahead. So with that, I'll be happy to address your questions.

Thanks, Bill. And maybe I'll start with the election. The upcoming election is in everybody's mind. What's your outlook for the U.S. defense budget? And how would a Trump versus Biden win impact that view?

Well, I think it's a very good question and one, that comes up quite a bit with investors, certainly, in the environment we happen to be on. But I think it's important to start with just the basics today, which is we do anticipate a continuing resolution through the end of the year. I think that's well expected. We're very calibrated for that. We see a '21 budget getting passed after the election towards the back end of the year, maybe into early January, pretty much in line with the budget agreement, which means it's roughly flat around $705 million in that range. And we're seeing good alignment on the line item between the house and the Senate. So I think that's going to happen later on this year. Beyond '21, we see a little bit of a push and pull between elevated threats and the higher deficits. We think that's likely resulting in a flattish budget outlook. We don't see a sequester like cliff on the horizon. We think it's going to be more of a smoother flow over the next number of years. We continue to see good strong bipartisan support for defense. We see in the last couple of years. You saw that back in July in the package of the NDA, both the house and the Senate, with overwhelmingly bipartisan numbers. Of course, we're watching the elections as everybody else is. But really, the threats of what matters in the environment we're in, they're real and again, I think there's a bipartisan recognition of the threat environment that happens to be out there. We also expect, between the Trump administration and potential Biden administration that they both stay largely aligned to the National Defense strategy, which is a focus on near pure threats. And I think when you see that, you'll see within the line items, you'll see a gradual shift in the budget from legacy systems to more advanced technologies.

That's really helpful. But in the event that the U.S. defense budget is cut, what platforms or programs do you think are most at risk for the industry? And are there any within the LHX portfolio that you would be worried about?

Well, in general, I think we're going to see a shift from legacy platforms that can't operate in a nonpermissive environment towards, again, new technology. So interconnected systems, resilient networks, unmanned is going to be an important part of the future. Remote sensing, particularly from space is going to be important, onboard processing, using AI tools, new weapon systems, new weapon platforms, I think that's going to be the shift in the budget. But the way I look at it is really not an either/or. I think you'll continue to see upgrades on legacy platforms, alongside with NextGen investments. We see that in our portfolio. We continue to compete, for example, a domestic F-16 upgrades on EW, the Next-Gen Jammer low-band on the Growler. You see EW platforms in the B-52. These are all platforms that will continue to fly for a number of years as you're starting to see more of a shift towards newer technologies. For us, at L3Harris, we don't produce platforms. We make the mission systems that make the platforms more effective. It's both on legacy as well as on next-generation systems. We're focusing our IRAD in that direction, and that's been a big focus of the company. So we've got a very diverse portfolio. There's not a single product line or business line, that's going to be a needle mover. So while we'll see some pullback in some areas, I think given our focus on new technologies, I think that's going to offset any pullback in any legacy platforms for L3Harris.

Great. And on -- one thing that we've been hearing more of in the past few years, and maybe it's something that you've seen for a while, but it's not percolating into the media, there's been a lot of discussion around multi-domain operations and multi-domain operation capabilities. What does this really mean for you? And do you believe that investments in MDO capabilities is a priority for the government given potentially tighter budgets?

Well, I think you said it right. I think the press is picking it up. But the concept has been around for a few years. In the Army, they call it multi-domain operations. In the Navy, it's distributed maritime operations. In the air force, it's ABMS. I mean, there's all these different acronym soup here, but it's all part of this broader JADC2 or joint all-domain command and control framework. It's kind of like the Internet of Military things that the DoD has been focusing on over the last number of years really against this near-peer threat we see in the future. I don't see it as just -- not just achieve, well, I think this is inevitable, actually. I think it's inevitable that this is the path that we're going to be on in some form. There are certain threats we know that are on the horizon that could only be addressed through a multi-domain solution, for example, hypersonic defense. You're going to need LEO, MEO from space, sensing and tracking of hypersonic weapons, you're going to need to see those sensing systems and tracking systems, trigger an effect from an airborne platform, a land platform, a maritime platform. And it will have to be done almost in real-time fashion given the speed of the hypersonic weapon. So I think you're only going to see -- and there's lots of examples like that. You're only going to see us being able to defeat an adversary using some sort of multi-domain solution. I think the approach that we're hearing about today, we heard this yesterday at AFA, the New Chief was talking about as well as Dr. Roper, about the approach on ABMS and JADC2. I think it's very pragmatic. It's about demoing new ways of connecting existing assets, existing UAVs, the existing platforms for new effects, and it's certainly one place that they're spending a lot of money. And there's a fairly large IDIQ. It's about $950 million. There's a lot of players on it. We're one of the few companies that's across all 7 categories. We've got a big stake in this ABMS future, we believe. So that's one piece of it is sort of new capabilities with existing platforms. And the other side, I think, is more importantly, more and more for us in the future is designing in multi-domain capabilities onto future platforms. And these are things that are on the drawing board, lots happening in the classified space. But it's really on both sides. I think over time, you'll see maybe these acronyms change because it's sometimes the creations of the appointees in the Pentagon. But the acronyms may change. The budget dollars may move around right now in the Air Force. It's just over $3 billion in the FYDP. It's about $300 million in fiscal '21. The numbers may move around, but I do believe that some sort of multi-domain operation is going to be core to the future fight just based on we know what the threat is from Russia and from China.

So that's really helpful backdrop, Bill, to understand the operating environment. I guess, you've talked about mid-single-digit growth for L3 over the coming years. What are the building blocks and key platforms to get you there? It looks like you've kind of hinted in a few in your previous comments already.

Yes. So look, we -- when we completed the merger, and we put the S-4 out, we talked about mid-single-digit, we outgrew that over the first year of our creation. We talked about this a little bit at the earnings release, mid-single-digit top line growth, driving double-digit earnings per share and free cash flow per share growth over the medium term. On the top line, we see really 3 big drivers to this. One is growth in core mission areas like communications and ISR and space and classified. These are all part of the future fight. They're all well-funded. We're focusing a lot of our IRAD dollars in that area. We've consolidated our spend, focused our spend in areas that we believe are crucial to the future fight. This is all about, for us, expanding from components to subsystems to full end-to-end mission solutions. And so that whole theme, we think we're in the right spot, and we think we can grow just on our core business alone. So that's number one. Two is all about revenue synergies. We've been talking a lot about that on our earnings releases. It's relatively small today. We feel good about what we're winning. We're winning more than 50% of the proposal we're putting in. And it's going to become more meaningful over time, probably towards the back end of '21 and certainly becomes meaningful in calendar '22. And the third part about this is really -- the third leg of growth is around international. We're less than 20% of our revenue coming from international sources. It's below our peers. We're focused. We're aligned on this. We're attacking it. And we do think that we have a good opportunity to outgrow peers in the international side. When you put those 3 pieces together, it gets us back into that mid-single-digit growth area on the top line. And of course, on the bottom line, growing double-digit free cash earnings per share is going to be driven by margin expansion from E3 synergies, working capital, there's a lot of good opportunities we're seeing there. Shareholder-friendly capital deployment to bring our share count down. And when you put those pieces together, you get double-digit earnings per share and free cash flow per share growth.

Thank you, Bill. And Jay, maybe switching gears to you, why can't LHX get to 20% margins, given the tailwind around synergies, operational excellence with the E3 program, you've got also program maturation in your portfolio, and you've got some portfolio shaping actions. How are you driving the business to increase margins going forward and get to that 20% plus?

Sure, Kristine. It's a great question. And first, I think we can, but we take a -- as Bill just mentioned, more of a balanced approach to growth. And there's 3 components to it. There's the revenue growth, and Bill just talked -- walked us through how we can deliver mid-single-digit growth. Margins are certainly a part of it as well as capital deployment that will all be enablers to continue double-digit growth. And the contribution of each will vary from year-to-year. And so going back to just specifically on margins, to your question, you look at where we are this year from -- our guidance was 17.5% plus. We define the plus to be around 10 to 20 basis points. You look at where we go from here from terms of synergies. By the end of this year, we'll be at $250 million. We'll hit our target of $300 million in 2021. So you just do that quick math, and it tells you that it will be around the 18% benchmark in 2021. Beyond that, as you mentioned rightly, we will see some benefits from portfolio pruning. So we'll see some addition from -- by subtraction. Other elements are, we have a decent amount of our high exposure on fixed-price contracts. So it enables us to really drive our operational excellence program in E3 and actually see those benefits be realized in our results in -- particularly in margins. The other element of growth, and I think Bill mentioned a little bit, too, is our international expansion, which those tend to be a little bit higher margins than domestic. And so when you put all those together, we do believe that there's certainly runway in margins. There are some headwinds that you have to deal with. There is a portion of our portfolio that is cost plus, and sometimes you have to reset margins on new contracts and also, as Bill mentioned, we also have investment requirements. But when you pull all of those together, we see more positive than negative and believe it's continued runway in our margins. So I won't give you specific target per se. But again, it's part of the formula and margins have room to grow from here.

Thanks, Jay. And when you look at your segments, is there more margin opportunity for the legacy Harris business or the legacy L3 heavy businesses? And where do you think you can take IMS and AS, in particular, from their current mid- to low single teens levels? And where can they go from there?

Yes. Let me -- maybe just to define that, the legacy kind of, call it, the legacy Harris business is probably a little bit more in space and airborne as well as communication systems. And then more of the legacy L3 portfolio setting in IMS, Integrated Mission Systems as well as our Aviation Systems business. And maybe I'll start with those with IMS and AS. You look at where we are this year with those businesses, we're in the, say, the low teens, anywhere between 13% to 13.5%. On the last call, I threw out there that IMS, as we were getting questions on their margins, probably be closer to 14.5% this year. But we believe there's room with the benefit of synergies as well as our operational excellence program for those businesses to go up to mid- to high teens. And there's really no structural reason why those businesses can't. And so we continue to follow the formula that I just previously talked about as far as our road map to higher margins overall. We believe that those business have more runway than, say, the legacy Harris businesses, which is the space and airborne and communication systems just because they're starting from a higher point. You're talking 23% plus in communication systems, and we're talking high teens in space and airborne. And so while there may be a little bit there, the greater opportunity is sitting in IMS and AS.

Thanks, Jay. Bill, on portfolio shaping, where is the biggest benefit to LHX? Is it management focus? Is it margins? Top line growth? Working capital? Or elsewhere?

Well, I think it's a little bit all of those. But primarily, it's around focus, and it's how we focus resources in general. It's capital, it's R&D and importantly, it's management time and management attention. And we want to make sure that those are focused on areas that drive the greatest value to owners and get out of those businesses or have businesses owned by somebody else who don't fit with us and distract us and distract our attention. I think we certainly have seen personally here in legacy Harris, struggling businesses can absorb a disproportionate amount of time and attention from management. The return on your investment is low in terms of your time and attention. And I think it's better placed on strategic assets. So I think a lot of the value is really around management focus.

I see. And so what's the latest on the time line and potential proceeds for the -- I think it was 10 -- 8% to 10% of revenues that you've identified for divestitures?

Yes. We're making good progress. I mean, we got out of the gate pretty quickly. This is something that Chris and I spend a lot of time on before close. In fact, we started almost from the day we announced that the transaction talking about what fit, what didn't fit with the overall portfolio, and that's been an ongoing exercise and will continue to be. But that bottoms-up part of analysis drove us to -- about 8% to 10% of our revenue we thought was not strategic. We're about 1/3 of the way through. So we had 3 transactions, 4 businesses with 3 transactions, just over $1 billion in proceeds, and we're using that now in Q3 to repurchase shares. The rest -- the other 2/3 are different stages of the processing. So some is in a sort of QOE book prep process, if you will. Some of our others are more advanced. As you know, nothing is really guaranteed until you sign and close on a deal. Pandemic slowed us down a little bit in Q2 and early Q2 and sometime early in the summer. But -- and we've seen early in Q3, a little bit more acceleration. We're -- I think, Q4 is going to be busier. Early '21 is going to be busier. We continue to be patient. We're going to be persistent, and we're going to make sure we maximize value through this. But it's really about businesses that should not be here, and we want to focus the time and attention on those that really matter.

Thanks, Bill. And on working capital, working capital is clearly a focus area for LHX. Where is this opportunity all coming from? And when do the benefits run out?